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Day after Halloween, nothing to be scared of!

We have been receiving a few questions on the effects of rising interest rates in bond portfolios due to inflation and actions by the Federal Reserve. As interest rates rise bond prices fall, people seemed worried that a rise in interest rates will be from inflation and that will have a negative impact on other asset classes, mainly equities. It is easy to say if one has a crystal ball. But let’s take a look at the reasons why interest rates have risen, an update on the Federal Reserve, and a reminder of the role of bonds in a portfolio.

The biggest driver of front-end (0-5yr) rates is the Federal Reserve. The Federal Open Market Committee (FOMC) met today and kept the Fed Funds Rate unchanged. They upgraded its assessment on growth and economic activity. They stroked a cautionary tale on inflation stating that core inflation remains soft with no clear evidence of a price pickup. The FOMC has laid groundwork to hike the Fed Funds rate 25 basis points at its December 13 meeting barring any exogenous shocks to the financial system.

Recently the 10-year rate had increased to 2.42% from a low of 2.04% on September 7th. Only 10 basis points of this was due to inflation expectations. The other 28 basis points were a combination of anticipation of short-end rates increases due to Fed rate hikes and balance sheet normalization by the Federal Reserve. The market is pricing in positive economic growth which has a high correlation to the 10-year rate. However, there are some forces that are keeping the 10-year rate down mainly from long dated pension and liability investors “reaching for” yield and foreign buyers (US rates look attractive to other foreign rates).

The most recent two weeks of interest rate volatility have alarmed many investors. Much of the volatility has to do with the market trying to play who the President appoints as the Fed Chair. The two likely candidates are Jerome Powell and John Taylor with current Fed Chairwoman Yellen sitting third. Kevin Walsh and Gary Cohn seemed to be out of the race. Markets think that a John Taylor Fed would have a high tolerance for higher rates and faster run off of the balance sheet driving rates up while a Powell Fed would be the status quo and maybe tend to be a bit more dovish (keeping rates low). Powell is leading the horse race down the back stretch. The President is supposed to come out with his announcement of the appointment before end of week.

Bonds still give diversification benefits and act as an insurance policy to extreme events. The insurance that bonds bring to a portfolio cannot be understated. With valuations of asset classes higher than other periods bonds do hold some value as “an anchor in the wind.” The insurance cost of bonds in a portfolio is on the higher side but much cheaper than June 2016 when the 10-year rate reached a low of 1.36%.

Few bullet points on interest rates:

Market is pricing in 88% rate hike in December and three more in 2018. If a large stimulus package comes from congress we could see quicker pace of rate hikes.

There will be some volatility in the interest rate markets as there is a shift to tighter monetary policy by global central banks.

Bonds still play a role in a portfolio and one can never predict exactly and how much interest rates will move.

Fear about the threat of higher interest rates driven by inflation crashing stocks is a little overdone. A small increase in inflation is exactly what the Fed is looking for and should help riskier assets including equities. Wage pressure has increased but it has not translated into the CPI numbers yet. I think the probability of an increase in rates from an inflation shock is low. Rates will rise from global balance sheet unwind and positive economic growth (3% GDP growth annualized q/q).

If you want to be the new Fed Chair, you can get a glimpse at the difficult task by playing a simulation built by the San Francisco Fed, click here.